1. Chapter 10

2. Cash Flows and Other Topics in Capital Budgeting

3. NET PRESENT VALUE (NPV) INTERNAL RATE OF RETURN (IRR)
NPV = IO
ACFt
(1 + k) t n
t=1 S n
t=1 S
IRR: = IO
ACFt
(1 + IRR) t

4. Capital Budgeting: the process of planning for purchases of long-term assets.
example:
Our firm must decide whether to purchase a new plastic molding machine for $127,000. How do we decide?
Will the machine be profitable?
Will our firm earn a high rate of return on the investment?
The relevant project information follows:

5. The cost of the new machine is $127,000.
Installation will cost $20,000.
$4,000 in net working capital will be needed at the time of installation.
The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase.
Simplified straight line depreciation is used.
Class life is 5 years, and the firm is planning to keep the project for 5 years.
Salvage value at year 5 will be $50,000.
14% cost of capital; 34% marginal tax rate.

6. CAPITAL BUDGETING STEPS
EVALUATE CASH FLOWS
DETERMINE RISK (DISCOUNT %)
MAKE ACCEPT/REJECT DECISION

7. Capital Budgeting Steps
1) Evaluate Cash Flows
Look at all incremental cash flows occurring as a result of the project.
Initial outlay
Differential Cash Flows over the life of the project (also referred to as annual cash flows).
Terminal Cash Flows

8. Capital Budgeting Steps
1) Evaluate Cash Flows
Terminal
Cash flow
Initial
outlay 1 2 3 4 5 n 6
. . .
Annual Cash Flows

9. Capital Budgeting Steps
2) Evaluate the risk of the project.
We’ll get to this at the end of this chapter.
For now, we’ll assume that the risk of the project is the same as the risk of the overall firm.
If we do this, we can use the firm’s cost of capital as the discount rate for capital investment projects.

10. Capital Budgeting Steps
3) Accept or Reject the Project.
WE KNOW THAT WE WILL BE LOOKING FOR THE IRR TO EXCEED THE DISCOUNT RATE AND A POSITIVE NPV.

11. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(Purchase price of the asset)
+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

12. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(127,000)
+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

13. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(127,000)
+ ( 20,000)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

14. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(127,000)
+ ( 20,000)
(147,000)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

15. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(127,000)
+ ( 20,000)
(147,000)
+ ( 4,000)
+ After-tax proceeds from sale of old asset
Net Initial Outlay

16. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(127,000)
+ ( 20,000)
(147,000)
+ ( 4,000)
Net Initial Outlay

17. Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(127,000) Purchase price of asset
+ ( 20,000) shipping and installation
(147,000) depreciable asset
+ ( 4,000) net working capital
proceeds from sale of old asset
($151,000) net initial outlay

18. Step 1: Evaluate Cash Flows
b) Annual Cash Flows: What incremental cash flows occur over the life of the project?

19. For Each Year, Calculate:
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

20. For Years 1 - 5: Incremental revenue - Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

21. For Years 1 - 5: 85,000 - Incremental costs - Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

22. For Years 1 - 5: 85,000 (29,750) - Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

23. For Years 1 - 5:
85,000
(29,750)
(29,400)
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

24. For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

25. For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow

26. For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
+ Depreciation reversal
Annual Cash Flow

27. For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
29,400
Annual Cash Flow

28. For Years 1 - 5: 85,000 Revenue (29,750) Costs (29,400) Depreciation
25,850 EBT
(8,789) Taxes
17,061 EAT
29,400 Depreciation reversal
46,461 = Annual Cash Flow

29. Step 1: Evaluate Cash Flows
c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow

30. Step 1: Evaluate Cash Flows
c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?
50, Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow

31. Tax Effects of Sale of Asset:
Salvage value = $50,000
Book value = depreciable asset - total amount depreciated.
Book value = $147,000 - $147,000
= $0.
Capital gain = SV - BV
= 50, = $50,000
Tax payment = 50,000 x .34 = ($17,000)

32. Step 1: Evaluate Cash Flows
c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?
50, Salvage value
(17,000) Tax on capital gain
Recapture of NWC
Terminal Cash Flow

33. Step 1: Evaluate Cash Flows
c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?
50, Salvage value
(17,000) Tax on capital gain
4, Recapture of NWC
Terminal Cash Flow

34. Step 1: Evaluate Cash Flows
c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?
50, Salvage value
(17,000) Tax on capital gain
4, Recapture of NWC
37, Terminal Cash Flow

35. Project NPV: CF(0) = -151,000 CF(1 - 4) = 46,461
Discount rate = 14%
NPV = $27,721
IRR = 21%
We would accept the project.

36. Incorporating Risk into Capital Budgeting
Risk-Adjusted Discount Rate

37. How can we adjust this model to take risk into account?
NPV = IO
ACFt
(1 + k) t n
t=1 S

38. How can we adjust this model to take risk into account?
NPV = IO
ACFt
(1 + k) t n
t=1 S
Adjust the discount rate (k).

39. Risk-Adjusted Discount Rate
Simply adjust the discount rate (k) to reflect higher risk.
Riskier projects will use higher risk-adjusted discount rates.
Calculate NPV using the new risk-adjusted discount rate.

40. Risk-Adjusted Discount Rate
NPV = IO
ACFt
(1 + k*) t n
t=1 S

41. Risk-Adjusted Discount Rates
How do we determine the appropriate risk-adjusted discount rate (k*) to use?
Many firms set up risk classes to categorize different types of projects.

42. Risk Classes Risk RADR Class (k*) Project Type
% Replace equipment,
Expand current business
% Related new products
% Unrelated new products
% Research & Development

43. Practice Problems: Cash Flows & Other Topics in Capital Budgeting

44. Problem 1a Project Information: Cost of equipment = $400,000
Shipping & installation will be $20,000
$25,000 in net working capital required at setup
3-year project life, 5-year class life
Simplified straight line depreciation
Revenues will increase by $220,000 per year
Defects costs will fall by $10,000 per year
Operating costs will rise by $30,000 per year
Salvage value after year 3 is $200,000
Cost of capital = 12%, marginal tax rate = 34%
Problem 1a 3

45. Problem 1a Initial Outlay: (400,000) Cost of asset
+ ( 20,000) Shipping & installation
(420,000) Depreciable asset
+ ( 25,000) Investment in NWC
($445,000) Net Initial Outlay 3

46. For Years 1 - 3: Problem 1a 220,000 Increased revenue
10,000 Decreased defects
(30,000) Increased operating costs
(84,000) Increased depreciation
116,000 EBT
(39,440) Taxes (34%)
76,560 EAT
84,000 Depreciation reversal
160,560 = Annual Cash Flow 5

47. Problem 1a Terminal Cash Flow: Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow 6

48. Problem 1a Terminal Cash Flow: Salvage value = $200,000
Book value = depreciable asset - total amount depreciated.
Book value = $168,000.
Capital gain = SV - BV = $32,000
Tax payment = 32,000 x .34 = ($10,880) 7

49. Problem 1a Terminal Cash Flow: 200,000 Salvage value
(10,880) Tax on capital gain
25, Recapture of NWC
214, Terminal Cash Flow 9

50. NPV = $93,044. Accept the project!
Problem 1a Solution:
NPV and IRR:
CF(0) = -445,000
CF(1 ), (2), = 160,560
CF(3 ) = 160, ,120 = 374,680
Discount rate = 12%
IRR = 22.1%
NPV = $93, Accept the project! 10

51. Problem 1b Project Information:
For the same project, suppose we can only get $100,000 for the old equipment after year 3, due to rapidly changing technology.
Calculate the IRR and NPV for the project.
Is it still acceptable? 3

52. Problem 1b Terminal Cash Flow: Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow 6

53. Problem 1b Terminal Cash Flow: Salvage value = $100,000
Book value = depreciable asset - total amount depreciated.
Book value = $168,000.
Capital loss = SV - BV = ($68,000)
Tax refund = 68,000 x .34 = $23,120 7

54. Problem 1b Terminal Cash Flow: 100,000 Salvage value
23, Tax on capital gain
25, Recapture of NWC
148, Terminal Cash Flow 9

55. NPV = $46,067. Accept the project!
Problem 1b Solution
NPV and IRR:
CF(0) = -445,000
CF(1 ), (2), = 160,560
CF(3 ) = 160, ,120 = 308,680
Discount rate = 12%
IRR = 17.3%
NPV = $46, Accept the project! 10

56. Problem 2 Automation Project: Cost of equipment = $550,000
Shipping & installation will be $25,000
$15,000 in net working capital required at setup
8-year project life, 5-year class life
Simplified straight line depreciation
Current operating expenses are $640,000 per yr.
New operating expenses will be $400,000 per yr.
Already paid consultant $25,000 for analysis.
Salvage value after year 8 is $40,000
Cost of capital = 14%, marginal tax rate = 34%
Problem 2 3

57. Problem 2 Initial Outlay: (550,000) Cost of new machine
+ (25,000) Shipping & installation
(575,000) Depreciable asset
+ ( 15,000) NWC investment
(590,000) Net Initial Outlay 58

58. Problem 2 For Years 1 - 5: 240,000 Cost decrease
(115,000) Depreciation increase
125,000 EBIT
(42,500) Taxes (34%)
82,500 EAT
115,000 Depreciation reversal
197,500 = Annual Cash Flow 59

59. Problem 2 For Years 6 - 8: 240,000 Cost decrease
( ) Depreciation increase
240,000 EBIT
(81,600) Taxes (34%)
158,400 EAT
0 Depreciation reversal
158,400 = Annual Cash Flow 59

60. Problem 2 Terminal Cash Flow: 40,000 Salvage value
(13,600) Tax on capital gain
15, Recapture of NWC
41, Terminal Cash Flow 62

61. We would accept the project!
Problem 2 Solution:
NPV and IRR:
CF(0) = -590,000
CF(1 - 5) = 197,500
CF(6 - 7) = 158,400
CF(10) = 158, ,400 = 199,800
Discount rate = 14%
IRR = 28.13% NPV = $293,543
We would accept the project! 63